Goodwill has long been a somewhat opaque, hard-to-define term. For accountants, goodwill is defined by Generally Accepted Accounting Principles as “an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized.”1

Case In Point: Goodwill in Valuation Cases: Not All Goodwill is Created Equal

Thu Dec 10, 2015

Goodwill has long been a somewhat opaque, hard-to-define term. For accountants, goodwill is defined by Generally Accepted Accounting Principles as “an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized.”1 In litigation, the concept of goodwill is often at issue, and a recent decision in a notable Texas Appelate Court case, K.T. v. M.T. , highlights this nuance, addresses the different types of goodwill, and identifies how goodwill can have potentially immense impacts on business valuation.

In this case, involving the value of a financial advisor’s business, the different types of goodwill and how transferability can differ depending on the type of business came to the forefront. Specifically, the case addressed the difference between personal goodwill and commercial goodwill (often called “enterprise” goodwill) as applied to the divorcing Husband’s financial advisory business. The experts for both Wife (appellant) and Husband (appellee) calculated vastly different business valuations based primarily on the concept of “personal goodwill.”2 The appeals court affirmed a trial court’s ruling that the majority of the goodwill in the subject business was personal goodwill, and that personal goodwill should be deducted from the value of the business in a matrimonial divorce setting.

Background

The Husband’s argument was that the value of his financial advisory business included a significant amount of personal goodwill. The Husband’s expert asserted that the Husband has personal goodwill because of the direct involvement the Husband has in the business and “without [his] time, toil, talent, skills, efforts, and reputation, that business is not going to be there, and that’s the essence of personal goodwill.” The Husband’s expert argued that personal goodwill can be difficult to separate from the individual business owner, whereas commercial goodwill is more associated with operating businesses not overly reliant on the owner’s personal service and not overly dependent on client trust in the current owner. In this manner, commercial (aka enterprise) goodwill is more consistent with the accounting definition of goodwill.

Experts on Goodwill

The Husband’s expert argued that the goodwill of the Husband’s business is not transferrable because of the personal nature of his business. The Husband’s business depended largely on the trust built up over time in the Husband’s advice and personal relationships with clients. Unlike other operating businesses such as manufacturers or service providers that do not require the same personal attention, the Husband’s client base and ultimate business value was argued to be inseparable from his own attention and abilities. As a result, the Husband’s expert argued that transferring ownership of the business and client base without a non-compete agreement from the Husband would not be possible. Even with a non-compete in place there was no guarantee that the Husband’s existing clients would remain intact under a new owner. The Husband’s expert argued that this nullifies any perceived commercial goodwill and renders it personal goodwill. The Husband’s expert argued that there is no discernible commercial goodwill or transferrable personal goodwill, and therefore there is no meaningful goodwill, resulting in the comparatively low $27,000 valuation, representing the Husband’s expert’s estimate of the company’s adjusted book value.

The Wife’s expert, on the other hand, valued the business by calculating excess earnings and then taking a discount of 25% for the “huge risk” of the Husband not running it.3 Similar to the Husband’s expert, the Wife’s expert acknowledged the personal goodwill tied up in a type of business like the Husband’s financial advisory practice. Unlike the Husband’s expert however, the Wife’s expert ultimately assigned the relatively small 25% personal goodwill discount factor, resulting in the business value of $413,683.

Ultimately, the Wife’s expert argued that the smaller goodwill deduction was warranted and the valuation was sound because “someone else could come in and….do a good job.”4

Valuation Methods of Experts

The Husband’s expert concluded on a value of $27,000, based on an adjusted book value estimate. The Wife’s expert argued in favor of an “excess earnings” valuation method5 whereby the earnings potential of the business is added to the business’s tangible assets value. The Wife’s expert asserted this method is commonly used for small advisory businesses such as the Husband’s. In stark contrast to the Husband’s expert’s valuation, the Wife’s expert asserted a value of $413,683. The lower court found in favor of the Husband. The Wife appealed the final decree that “commercial goodwill” be excluded from the value of the Husband’s business, “awarding the entire value of the Husband’s community property deferred compensation account to the Husband, resulting in an unfair and unjust property division.” 6

While both experts adopted positions consistent with the guidance in Texas that personal goodwill is not divisible upon divorce, each expert approached the valuation very differently. The Wife’s expert used an unsupported and unsubstantiated 25% adjustment factor to account for personal goodwill, while the Husband’s expert ascribed no transferable personal goodwill value to the business, effectively a 100% adjustment factor for personal goodwill. The court concluded “that legally and factually sufficient evidence supports the trial court’s finding that the business was valued at $27,000 as testified to by Husband’s expert.”7

Takeaway

According to the decision, Texas case law has typically distinguished between personal goodwill and commercial goodwill “that arises from its location, its well-established and well-recognized name, or something that otherwise separates it ‘from the skills or attributes of an individual member.’”’8 Further, only “goodwill that exists separate and apart from a professional’s personal skills, ability, and reputation is divisible upon divorce.”9

Since Texas appears to conclude that personal goodwill should not be divisible in a matrimonial divorce valuation, it is necessary to value personal goodwill in Texas. In addition to considering how different jurisdictions treat different forms of goodwill, this decision reminds us that valuation experts should be as specific, factual, and supportive of whatever approach they use to value personal goodwill. For example, it is helpful to consider whether the particular personal goodwill in question would transfer easily. As countless earn-out agreements in professional service industry acquisitions can attest to, acquiring firms often obtain selling firms’ key owners or proprietors’ continued service and management of client relationships post acquisition. Even with such agreements, however, forecasted earnings do not always materialize. Goodwill will likely remain an opaque term that cannot be definitively “identified and separately recognized,”, and valuations of professional service practices like the one at issue will continue to remind us that all goodwill is not created equal.

Duff & Phelps’ Case In Point is a bi-monthly e-newsletter covering one topic from one decision, always from a valuation and damages perspective.